Low-Income Housing Tax Credit: Overview & Ownership Structures

1. Low Income Housing Tax Credit 101 Basics and Refresher Course Diane Corbett Lisa Pekkala 2019 Applegate & Thorne-Thomsen, P.C. Investor & Syndicator Boot Camp, September 9, 2019

2. Overview of the Tax Credit Program • Subsidizes cost of providing housing to people whose income is below 60% of the area median income (“AMI”) • Benefits • Affordable housing for tenants • Tax credit equity reduces amount of debt needed to finance development • Reduced debt allows for project to support debt service at restricted rents • Investor gets tax benefits and/or CRA benefits • Governing Rules • Code Section 42 and Regulations • Legislative Modifications • Housing and Economic Recovery Act of 2008 (HERA) • Protecting Americans from Tax Hikes Act of 2015 (the PATH Act) • H.R. 1625, the Consolidated Appropriations Act, 2018 • Partnership Tax Rules

3. Overview of the Tax Credit Program • Administering Agencies • All 50 states plus Puerto Rico, Guam, the Northern Mariana Islands, City of Chicago and the USVI • Qualified Allocation Plan (“QAP”) • State housing priorities • Credits Available to the Owner of the Property • 10-Year Credit Period • Begins in year in which the building is placed in service, or at the owner’s election, the following year • First year phase-in of credits, with additional credits taken in year 11 • 15-Year Compliance Period • Recapture • Extended Use Period • Credits and Losses

4. Ownership Structure • Limited Partnership or Limited Liability Company • GP/MM owns 0.01% • Controls and operates the project • Typically makes nominal capital contribution at closing • Typically receives up to 90% of residual cash flow and capital transaction proceeds • Typically earns fees (either directly or through affiliates) • LP/IM owns 99.99% • Passive investor with certain consent and GP removal rights • Makes capital contributions as project achieves key benchmarks • Typically receives 10% of residual cash flow and capital transaction proceeds • Primary return is in the form of tax credits and deductions • LIHTC allocated to partners in the same manner as depreciation

5. Sponsor Investor Fund LP/LLC General Partner • 99.99% interest (incl. deductions and tax credits) • 10% cash flow and capital transaction proceeds • Asset Management Fee • 0.01% interest (incl. deductions and tax credits) • 90% cash flow and capital transaction proceeds • Reasonable fees (e.g. Incentive Fees) Partnership Apartment Building Ownership Structure Upper Tier Investor Developer Developer Fee

6. Tax Credits vs. Tax Deductions • Tax Deduction: reduces the investor’s Taxable Income (i.e. the amount of income that is subject to tax) by the amount of the deduction • Taxable Income x Tax Rate (21% for corporations) = Net Tax Liability • Each $1.00 of deduction reduces Taxable Income by $1.00 • So, each $1.00 of deduction reduces the Net Tax Liability for corporations by $0.21 • Tax Credit: reduces the investor’s Net Tax Liability (i.e. the taxes owed after applying deductions, etc.) by the amount of the credit • Taxable Income x Tax Rate (21% for corporations) = Net Tax Liability • Each $1.00 of credit reduces the Net Tax Liability by $1.00 • So, each $1.00 of credit reduces total taxes owed by $1.00 (dollar for dollar reduction)

7. Tax Credits vs. Tax Deductions

8. Practice Note: Understanding Basis and Timing Adjusters in the LPA Basis Adjuster – makes the investor whole if the amount of actual credits delivered is less than the projected credits Timing Adjuster – makes the investor whole if credits are delivered later than anticipated Tax Credit Investor’s Investment • Tax Credit Investor typically investing in: • Tax Credits • Tax Deductions • Community Reinvestment Act (CRA) Credits (in some cases) • Paying $0.XX per credit today for future stream of credits and deductions over 10 years • Investor’s investment pricing is affected by many factors, including: • Amount of projected credits • Amount of projected deductions (e.g. interest on project loans, depreciation, fees) • Timing of credit delivery and deductions (e.g. lease-up schedule, bonus depreciation, tax-exempt use property, simple vs. compounding interest, cash vs. accrual basis fee recipients)

9. Types of Credits • 9% Credits • Allocated credits • For new construction and rehab costs only • 4% Credits • As-of-right credits based on the project being financed with tax-exempt bonds • Acquisition Credits • May be earned in both 9% and 4% deals for the costs of acquiring an existing structure • Credits calculated at the 4% credit rate

10. 9% Credits – New Construction/Rehab • Used in calculating credits for new construction and rehab costs in allocated credit deals • Each State receives a limited amount of credits annually to allocate to projects • $2.35 per capita; or • $2.69 million, whichever is greater • Increased annually for inflation • State may receive additional allocations that are not used by other states • State awards credits to projects in accordance with QAP • Also known as the “70 Percent Value Credit” because credits used to be calculated using a percentage that would yield, over the 10-year credit period, a present value equal to 70% of the qualified basis of the building • For allocations after July 2008, the rate is fixed at 9.00%

11. 9% Credit Calculation

12. 4% Credits – New Construction/Rehab • Projects eligible for credits as-of-right provided that: • Project is financed with tax-exempt obligations subject to the State’s volume cap • If at least 50% of the Project is financed with tax-exempt obligations, the Project can claim credits on 100% of its eligible basis (the “50% Test”) • If less than 50% of the Project is financed with tax-exempt obligations, the Project can only claim credits on the portion of eligible basis financed with tax-exempt obligations • Project meets the threshold requirements under the QAP (“42(m)(1) determination”) • Amount of credits can’t be more than the Issuer determines is necessary for the financial feasibility of the Project (“42(m)(2) determination”) • Also called the “30% Present Value Credit” because credits are calculated using a percentage that will yield, over the 10-year credit period, a present value equal to 30% of the qualified basis of a building • The 4% rate has fluctuated over time between 3% and 4%; the September 2019 rate is 3.20%

13. 4% Credit Calculation

14. Practice Note: Acquisition Credits are Tricky! Acquisition Credits contain many traps for the unwary! In particular, there are very specific rules around the prior ownership of the building throughout its life and around transfers of the building within the last 10 years (to be discussed in more detail in the LIHTC 201 panel). Always talk with tax counsel before transferring ownership of an existing building – or the ownership interests in an existing building – if you intend to later claim acquisition credits with respect to that building. 4% Credits - Acquisition Credits • 4% credits are also available for the costs in acquiring an existing building provided that certain rules are met including: • Building Purchase Test • 10 Year Hold • Anti-Churning Rules • Minimum Rehab Test • Only 4% credits may be taken on acquisition costs (even if 9% credits are taken on rehab costs) • No basis boost allowed on acquisition costs • LIHTC 201 Panel will discuss special rules and requirements

15. Computing LIHTC Credits are computed as follows: And the Applicable Percentage will be either or both of the following: Example – Page 7 of Sample Projections (reflects an acq/rehab financed by tax-exempt bonds)

16. Credit Calculation Example 9% Example: 4% Example: • Credit Limitation - Lesser of the amount calculated or the amount awarded by the Credit Agency • It is common that the Credit Agency will cap the credits for a Project to an amount lower than calculated by the above calculation (Excess Basis)

17. Practice Note: Filing a Rate Lock Election The Treasury Regulations specifically outline what constitutes a valid rate-lock election, and credit agencies have disallowed rate-lock elections that do not satisfy those requirements. Once the time period for filing has passed, the rate lock election cannot be fixed prior to placement in service. It’s a good idea to talk with your attorney before submitting a rate-lock election form to make sure that the Treasury Regulation requirements are satisfied. Credit Rate – Applicable Percentage • The Applicable Percentage - either (i) the rate in effect when the building is PIS or (ii) if earlier, the rate in effect when a rate lock election is made • Rate lock – Project can elect to “lock-in” the applicable percentage ahead of the building being placed in service to avoid uncertainty as to rate • 9% Credits – The rate lock election is made during the month in which a binding commitment for a LIHTC allocation is signed by the owner and Credit Agency. The binding commitment may be a reservation or an allocation • 4% Credits – The election is for the month in which the bonds are issued • Filing of Election • Must be filed by the 5th calendar day of the month after election is made • For bond deals, if Issuer is not the Credit Agency, must include an Issuer’s certification as to the month in which the bonds were issued and the aggregate basis of the building and land that is anticipated to be funded with tax-exempt bonds

18. Qualified Basis Computation

19. Eligible Basis – General Concepts • General Rule – eligible basis equals adjusted basis (depreciable basis) of the residential rental space • Eligible Basis is determined separately for new construction/rehabilitation and acquisition costs • Tax Rules – all expenditures will have a specified tax treatment • Capitalized into cost of building and recovered over a specified “class life” through annual depreciation deductions • Costs that are incurred during the production period of property • Also includes personal property and site work • Once property is in service, costs may be expensed immediately in the year they are incurred (or accrued) • Amortized over a specified period and deducted over that period (organizational costs, loan fees)

20. Eligible Basis – Construction/Rehab • New Construction: • Hard and soft construction costs, including Developer Fee • Exclusions and Exceptions • Rehabilitation: • Hard and soft construction costs, including Developer Fee • Minimum rehab costs - $7,000 per unit or 20% of acquisition costs

21. Practice Note: Acquired Reserves If the seller will be transferring project reserve accounts to the new owner as part of the sale, the building’s acquisition basis will be reduced by the amount of those acquired reserves. This can cause an unexpected reduction in tax credits if the parties are not aware that the reserves will be staying with the project. Always check with the seller to confirm whether the reserve accounts will stay with the project as part of the real estate transfer. Eligible Basis – Acquired Building • Existing Buildings – cost of purchasing the building, excluding land • 4% Credits only – acquisition basis is only eligible for 4% credit, regardless of whether there is tax-exempt bond financing • Must also have Rehabilitation Credits – LIHTCs are not allowed for acquisition costs unless credits are also allowable with respect to the rehabilitation of the building • Requirements for Acquisition Credits: • Purchase • 10-year Rule • No prior PIS by related party • Exceptions • Tax Credit 201 Topic!

22. Eligible Basis – Special Issues • Some costs are easy to characterize as building costs • Gray areas • Pre – vs. post- construction costs • Determining which asset a cost relates to • Allocation between Land and Building • Construction Loan Fees and Interest in Occupied Rehab • Relocation Costs • Bond Issuance Fees • Commercial Space Costs • Amenities (parking, laundry) • Reductions for Historic and Energy Credits • Deduct tax-exempt bond proceeds in 9% deal • Reduction of Federal Grants that finance construction

23. Qualified Basis Computation – Applicable Fraction

24. Practice Note: Scattered Site Projects Special rules apply to scattered site projects (projects containing multiple buildings that are not located on contiguous parcels of land). Typically scattered site projects must be 100% rent (and income?) restricted in order to qualify as a single project. Applicable Fraction • The Lesser of: • The Unit Fraction (low-income units/total residential units); or • Floor Space Fraction (low-income unit floor space/total residential rental unit floor space)

25. Qualified Basis - Example

26. Practice Note: QCT and DDA Designations HUD updates its QCT and DDA designations annually. A project can be in a QCT or DDA at the time of the application but fall out of the QCT or DDA by the time the carryover allocation or bonds are issued! Always check your project’s QCT/DDA status each year! That said, if your project falls out of a QCT or DDA, don’t panic. There are special rules that allow for a project to maintain its basis boost after falling out of a QCT or DDA if certain requirements are met. Eligible Basis – Basis Boost • 130% Basis Boost - Eligible Basis for new construction or rehabilitation costs is increased by 30% if the building is located in a “qualified census tract” (“QCT”) or “difficult development area” (“DDA”) (as determined by HUD), or if the project is designated as needing a boost by the Credit Agency (9% deals only) • QCT – high poverty area • DDA – high cost area • Discretionary – other, as determined by credit agency

27. Eligible Basis – Example (new construction)

28. Compliance, Definitions and Procedural Issues • Compliance Period and Recapture • Minimum Set-asides • Rent Restricted • Next Available Unit Rule • Vacant Unit Rule • Allocation Process and Documentation • 9% Projects • 4% Projects • Extended Use Period

29. Qualified Low-Income Building • LIHTC is available only for a Qualified Low-Income Building • A Qualified Low-Income Building is any building which is part of a Qualified Low-Income Housing Project • Qualified Low-Income Housing Project – must meet one of the following minimum set-aside requirements: • 40/60 Test - at least 40% of the residential rental units must be both rent restricted and occupied by individuals whose income is 60% or less of area gross median income (“AMI”), adjusted for family size • 20/50 Test - at least 20% of the residential rental units must be both rent restricted and occupied by individuals whose income is 50% or less AMI, adjusted for family size • Income Averaging – at least 40% of the residential units must be both rent restricted and occupied such that the average income for each unit does not exceed 60% (more to come!)

30. Qualified Low-Income Buildings • Definition of Rent Restricted – A unit is “Rent Restricted” if gross rent does not exceed 30% of the qualifying income levels in one of the set aside tests • Restricted rents are determined using 1.5 persons per bedroom rather than actual number of occupants. • Rental assistance provided by federal, state and local agencies is not considered rent paid by the tenant; utility allowances are included • Minimum Set-Aside Is Selected – The project must elect one of the three set aside tests (40/60, 20/50 or income averaging) for the project as whole

31. Practice Note: Traps for the Unwary: First Year Credits In addition to typical first year credit delivery issues like timing adjusters and placed-in-service deadlines, the first year of the credit period can contain many traps for the unwary. These can include inadvertently generating “2/3 credits” if 100% of the units in a building are not occupied by qualified tenants by the end of the first year of the building’s credit period or “burning credits” in an occupied rehab deal where the credit period begins before the investor is admitted. Always alert your deal attorney to deals with tight lease-up schedules or where tenants will remain in place throughout the rehab. Your attorney can help you reduce your risk of unintended consequences. If you’re not sure if your deal falls into that category, just ask! First Year Credits • A unit is not a low-income unit unless it is occupied by qualified low-income occupantsand is rent restricted • First year credit phase-in rule applies to reflect varying monthly occupancy during lease-up; unused credit is available in year 11 • 9% Projects with excess basis may still be able to take full year of credits

32. Next Available Unit Rule • De Minimis Increase in Income - No recapture if a previously qualifying tenant’s income goes up by 40% or less • Rule for 20% @ 50% or 40% @ 60% Projects • If tenant income exceeds 140% of the applicable 50% or 60% Area Median Income (“AMI”) limitation, then no unit will stay in compliance if the next available unit in the building is rented to a tenant with qualifying income • Rule is easily met for 100% LIHTC Projects • Rule for Income Averaging – if income of tenant goes over 140% of greater of 60% AMI or the limitation for the unit, then no recapture if next unit is rented to a qualifying tenant • Application of this rule is unclear and most states prohibit income averaging with market rate projects • See LIHT 201 Session for additional discussion

33. Vacant Unit Rule • A Vacant Unit will continue to be in compliance if reasonable attempts are made to rent the next available unit of equal or smaller size to an income qualified tenant • Reasonable Attempts means that efforts toward marketing and renting a unit that is suitable for occupancy must be made. This includes but is not limited to newspaper advertisement, vacancy posting at project site, internet, telephone outreach, etc. • A unit must have been occupied by an income qualified tenant before the vacant unit rule will apply

34. Extended Use Agreement • A building will be eligible for LIHTC only if an extended low income housing commitment, with an affordability term of at least 30 years, is in effect as of the end of the taxable year in which any credits are to be taken • Termination of Extended Use Period – The extended use period is terminated in two situations: • Foreclosure of the Qualified Low-Income Property • A failure of the housing credit agency to provide a buyer with a “Qualified Contract” for the project who will maintain the project as a qualified low income project. The Agency must locate a qualified buyer within 1 year of notification by the owner • Notwithstanding the termination of the extended use period, low-income tenants may not be evicted (other than for cause), nor may rent be increased for a period of three years following such termination

35. Fifteen Year Compliance Period • Rule - A Qualified Low-Income Housing Project must comply continuously with the minimum set-aside requirement, i.e., the 20/50, 40/60 or income averaging tests, for the full 15 year compliance period • Failure to meet requirement Minimum Set-Aside - results in a complete invalidation of the project as an LIHTC and a recapture of tax credits • Failure to Maintain Applicable Fraction - any reduction in the number of qualifying units originally taken into account for the calculation of qualified basis, and, hence, the calculation of the credit amount, will result in partial recapture

36. Recapture Events • Change in ownership • Transfer of building • Change in members of Owner – 1/3 of interest • No immediate recapture if reasonably expected that the building will continue to be operated as a qualified low-income building for the remaining Compliance Period • Change in Qualified Basis • Reduction in Applicable Fraction • Failure to meet minimum set-aside • Impermissible rent increases • Disqualified tenants • Change in unit mix • Habitability • Exception for de minimis increase in tenant income • Vacant units (reasonable attempts to rent)

37. Recapture, continued • Reduction in Eligible Basis • Conversion to non-residential use • Casualty loss • Both as determined at the end of the first year of the Credit Period • Recapture Amount: • Accelerated portion of credit • Years 1-11 – 1/3 of all prior credits • Year 12 – 4/15 of credits • Year 13 – 3/15 of credits • Year 14 – 2/15 of credits • Year 15 – 1/15 of credits • Plus interest on the recaptured amount

38. Allocation Process and Documents – 9% Credits • Application • Reservation • Carryover Allocation • 10% Test

39. Practice Note: 10% Test Deadlines While the Code requires that the 10% Test be met within one (1) year of issuance of the carryover allocation, credit agencies often have earlier deadlines. Be sure to check your reservation letter, carryover allocation, and/or QAP for the credit agency’s 10% Test deadline requirements – they may be earlier than the Code deadline! 9% Credits - Carryover Allocation • Carryover Allocations are the typical method in which credits are allocated • Timing - Credit Agency must issue carryover in the year of the credits that are being allocated (i.e., if 2019 credits are being used, then the Carryover Allocation must be allocated during the 2019 calendar year) • Carryover cannot be issued before or after the calendar year of the credits • 10% Test for Carryover Allocations – Project must spend at least 10% of the project land and building costs within 1 year of the Carryover • 10% Certification - Must send an accountant’s report to the Credit Agency certifying that the 10% requirement was met • Placement in Service Deadline - Project must be placed in service by the end of the 2nd calendar year after the Carryover Allocation is issued

40. Allocation Process and Documents – Tax-Exempt Bond Financed Projects • Application (May be separate for Credits and Bonds) • 42(m)(1) Letter – Authority Determination of Satisfaction of QAP Requirements • 42(m)(2) Letter – Issuer Determination of Financial Feasibility • 50% Test • Bond amount must exceed 50% of basis of land and buildings • Tax Credit Rate Election (and Issuer Certification, if applicable) • Additional Bond Documents • Resolution • Bond Counsel Non-taxability Opinion • Form 8038 – evidence of Volume Cap • 95/5 AUP or Taxpayer Certificate

41. Practice Note: Failure to Meet the 50% Test The 50% Test can have dramatic consequences if not met. Most LPAs provide that the Developer Fee will be automatically and irrevocably reduced in order to lower the project’s eligible basis and cause the 50% Test to be met if necessary. Tax-Exempt Bond Financed Projects – 50% Test • 50% Test –4% Credits are automatically available with respect to all of a building’s Eligible Basis as long as the tax-exempt bonds finance 50% or more of the aggregate basis of the building and land • Failure of 50% Test – If the 50% test is not met, LIHTC will only be available for the percentage of the building’s Eligible Basis financed by the tax-exempt bonds